Should Asset Allocation Be Tended To With Every Investment

The Asset Allocation formula is the mission statement that defines the long term structure and nature of the portfolio. By simply stating, for example, that the portfolio is to be 70% invested in equities and 30% in fixed income, an investor has proven that: (1) he has analyzed his personal situation carefully and, (2) determined that this structure is most likely to achieve his long term goals.
Asset Allocation is often misused and abused in an effort to superimpose a valid investment planning tool on speculation strategies that have no real merits of their own. For example, “annual portfolio repositioning”, “market timing adjustments”, and shifting between Mutual Funds. To be effective, Asset Allocation must be implemented as an on-going process that is to be tended to with every investment decision.

The Asset Allocation Formula itself is sacred, and if constructed properly, should never be altered in any respect due to conditions in either equity or income markets. Changes in the personal situation, goals, and objectives of the investor are the only issues that can be allowed into the Asset Allocation decision making process. It operates above the whims and cycles of the markets — Income or Equity.

Read

Cost Basis is the total amount paid for a security, any security, in the portfolio. The cost basis of a dollar of cash or money market is $1.00. Cost basis includes commissions and fees, and will be reduced on occasion when returns of capital are distributed. It is the very foundation of The Working Capital Model.

To illustrate, let’s start with a portfolio of $100,000 in cash. (The size doesn’t matter.) We expect to invest $70,000 of this in equities and the remainder in fixed income. Once the portfolio has been constructed, the Working Capital total will remain at $100,000 until there are cash additions or withdrawals, realized gains or losses. Day to day changes in Market Value are ignored.
As cash increases from income and from deposits it becomes a part of the Working Capital total and is reinvested in a way that maintains the 70/30 Asset Allocation, based solely on cost basis. Thus, both investment buckets are constantly growing, as is the income generated from the portfolio, while the Asset Allocation is being maintained with no unwarranted influence from current market conditions.

In The Working Capital Model, Cost Basis is also used for all diversification calculations.

Cash Flow then becomes the engine that propels The Working Capital Model forward toward goal achievement. It is only fitting and proper that the successful investment portfolio has this common ground with the successful business entity of any size.

Performance analysis becomes much more productive and forward going because both future predicting and comparing with arbitrary indices/averages is eliminated. Year-end adjustments are unnecessary. Cash Flow analysis shows how effective the allocation formula is and helps isolate how effectively the investor is managing each investment bucket.

Investment Performance Evaluation should be a measure of the extent to which a goal or objective has been achieved. The Working Capital Model facilitates the clear analysis of goal achievement based solely on each investors unique portfolio structure. Market value analysis, on the other hand, tells you nothing about progress toward your long term income goals or the appropriateness of your Asset Allocation.
Three specific numbers are important to long term Working Capital growth:

Gross Realized Earnings as a percentage of beginning Working Capital. This number should be better than the One Year CD Rate at the beginning of the year.

Gross Realized Capital Gains as a percentage of the Cost Basis of Securities Sold. This percentage should be right around the profit taking target you’ve set for yourself. You may also want to determine the Average Holding Period of each security sold . Shorter holding periods enhance portfolio working capital growth. It is important to set a reasonable target, one that can be achieved frequently throughout the year. Three 8% gains may not be exciting, but they can produce more revenue than one 20%er.

Growth in Working Capital as an annual percentage. A negative number in this area is totally unacceptable and should (almost) never occur. If it does, the portfolio manager (investor) has: (1) allowed too much risk into the security selection process, or (2) realized losses on older holdings that could not be given up on too quickly.

The actual WC growth rate will be somewhere between the target profit taking rate for equities and the average yield for fixed income — thus, it depends upon the asset allocation (the size of each bucket), which depends on the age, circumstances, and risk tolerance of the investor. Hey, is this easy or what.

As portfolio Working Capital grows, so does the income that it generates — there will always be some uninvested cash looking for a home. This is a good thing and should not be tinkered with by applying artificial or automatic reinvestment mechanisms.

Every dollar deserves to be allocated separately to the appropriate bucket, and there are times when investment opportunities in the equity market are few and far between. Income Securities can and should be purchased whenever the allocation formula warrants because? Because it is an income compounding decision, not a price decision.

Similarly, because of the disciplined investor’s dedication to the profit taking purpose of the equity allocation of the portfolio, large amounts of Smart Cash will accumulate with broad advances in the Stock Market. (Smart Cash is defined as cash that results from the realization of profits plus income generated by securities in the portfolio).

This process is not a hedge on anything, and not some form of market timing. It’s simply some realized profits that are earning some compound interest until new opportunities arise. [Yes, Virginia, compounding is still an important growth provider.]
About the authorSteve Selengut
Can be contacted steves AT sancoservices DOT com

2 Responses

Trying to play the market without spending hours every day can be very risky. Sometimes it is best to just make a decision on how to allocate investments, based on risk tolerance (Making maximum money is less important that sleeping soundly at night) and let it ride through the ebbs and flows and fluctuations of the market.